An Outdated Money Script
Home equity is overrated.
Buying a home has been revered as the pinnacle of good financial decision making. Your parents, grandparents, and great grandparents bought a home so you should too, right?
This belief has been passed on from generation to generation and is not serving you.
When looking at the balance sheet for the average American, a home makes up the largest asset. For many, this is the biggest financial decision you will ever make. Contrary to what the world tells you, you can progress into adulthood and financial independence without purchasing a home.
I hear frequently that buying a home builds “equity” and renting is “throwing money in the garbage.” While there is some truth to this statement, it doesn’t tell the whole story. The connection between buying a home and good financial decision making is severed. Buying a home is an emotional decision - not a financial decision.
Why?
Stocks outperform home equity. A homeowner's initial purchase costs and ongoing maintenance are costly. There are better places to invest (and accumulate) a home down payment.
Your decision to buy a home may prolong financial independence versus achieving it.
“Millennials Team Up to Fulfill the Dream of Homeownership” was the title of a recently published article in the Wall Street Journal. The article describes millennials who are “sick of paying rent and building no home equity.” This theme is pervasive and shows us how deep rooted our beliefs about home ownership go.
When you compare the appreciation of homes to the appreciation of the stock market, it’s hardly a fair comparison. Consider below, the Case-Shiller U.S. National Home Index which measures the value of single-family housing within the United States versus the S&P 500 which represents the 500 largest U.S publicly traded stocks.
*My Calculations: Data used available upon request
The chart shows the percent change of single family homes dating back to 1987. Single resident real estate appreciated 4.16%/yr over this time compared to a 8.25%/yr for the U.S. stock market. After inflation we’re looking at a 1-2% appreciation for your home and 6-7% for the U.S. stock market.
The premium for owning stocks over a home is 5-6% per year.
Buying a home is taking a concentrated bet on a single asset. If I told someone to borrow 20 times their net worth and place it all into one stock (that’s labor intensive to sell) and hope it goes up - people would think I was crazy! Yet, when buying a home many don’t think twice.
Price appreciation is a valuable component but doesn't tell the whole story. Considering the costs to purchase and maintain a home, we start to gain clarity on the true costs to home ownership.
When you first purchase a home you incur the following costs:
Closing costs (appraisals, earnest money, appraisals/titling/application/lender fees, etc.)
Transfer tax
Real estate agent commission (if applicable)
Closing costs range from 2% - 5% of the purchase price of a home. Transfer tax in Delaware is 4% (split between buyer and seller). Real estate agent commission can range from 2% to 7%. This means an 6% to 14% excess cost on top of the purchase price to secure your home. For a $300,000 home this is an additional $18,000 to $42,000.
After purchasing a home you are now responsible for the ongoing maintenance, property taxes, and home insurance. General rule of thumb for ongoing maintenance has been 1% of the purchase price per year. Property taxes vary based on where you live. If you live in the lucky state of Delaware, property taxes are the fourth-lowest nationwide at 0.51%. Although for southern Delawarians this will soon change. If you live in the unlucky state of New Jersey this number hovers around 2.4%. Insurance for homeowners is on average 667% more expensive ($1,200/yr for home owners and $180/yr for renters).
Keeping with our $300,000 home purchase your ongoing costs are 1.51%/yr plus $1,020 for insurance (cost above renters insurance) or $5,550/yr.
One overlooked cost when purchasing a home is opportunity cost.
Purchasing a home requires a down payment and time to accumulate that down payment (which can take months, likely, years, to accumulate in low interest bearing accounts). To receive more favorable lending terms, you’ll want a good loan-to-value ratio. This is usually 80% of the purchase price of the home. The remaining 20% is left for you to pay upfront in the form of a down payment.
The opportunity to invest that 20% down payment, and time invested in creating that down payment, into the stock market as opposed to your home is your most underrated (& expensive) cost.
Let’s play out this idea.
You purchase a $300,000 home. 20% down payment is $60,000. This is accumulated through 5.7 years assuming a 15% savings rate on a $70,000 salary. Assume rent is the same cost as a mortgage at $1,476/mo. Considering property taxes, maintenance, and insurance (as calculated above), cost of living for the homeowner is $23,262/yr. Considering renters insurance plus rent, cost of living to a renter is $17,892/yr (renters do not pay for maintenance or property taxes). This $5,370 surplus to the renter can now be invested into a taxable brokerage account.
At the end of a 30 year period (plus the 5.7 year runway for renters), using returns depicted above, we see the following:
Home owner: $723,153
Renter: $1,159,829
The renter yields $436,676 more than the homeowner.
All this said, what should you do?
Truthfully, it depends. Renting and owning can both be the right decision depending on your circumstances and preferences. Some of those personal decisions are as follows:
You live in rural areas where renting is not an option (or renting is exorbitantly high)
You are certain of your permanence in a location
You crave customization
Your significant other wants to (choose your battles wisely)
If any of these variables are questionable - consider renting.
Where you live can be an emotionally meaningful experience. You can still build wealth by both buying or renting. There is no one-size-fits-all solution. Furthermore, not every decision has to be made with calculators and spreadsheets. As Tim Maurer states, personal finance is more personal than finance.
“Personal finance is more personal than finance”
Personally, I rent and will continue to do so for as long as I can for all the reasons I mentioned above. Will I buy a home eventually? Maybe. But will I buy the home because I think it’s a good investment - absolutely not.